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Sunday, 31 March 2013

Sukuk (Islamic bonds) find favour in Australia


Wilkins’s interest in takaful extends beyond viewing Asia as an important growth market for IAG: he assisted with the preparation of Australia as a Financial Centre, a report released in late 2009, which recommended Australia pull down tax barriers in order to encourage Islamic finance. The federal government is yet to respond to a subsequent Board of Taxation review.
Wilkins stresses it is early days for IAG’s plans in Malaysia given the government is not issuing new takaful licences. But the growth is hard to ignore. “The takaful sector is likely to grow by about 20 per cent a year there,” he says.
Indonesia is also a target market for IAG and, being the largest Muslim state in the world, is another obvious market for takaful. “Given our interest in south-east Asia, and specifically Malaysia and Indonesia, our shareholders would at least expect us to explore the possibilities,” Wilkins says.
Under Islamic law, in order to fund its takaful liabilities, IAG would need to invest the cash flows received from policyholders into sharia-compliant products such as sukuk, or Islamic bonds.


Outside the Middle East, Malaysia has become the chief market to raise and trade Islamic finance instruments, and the vast majority of sukuk issuance now occurs there. At present, there is a low supply of issuers, compared to demand from investors, which is contributing to low yields.
Sukuk issuance dropped off during the global financial crisis but the instrument’s prohibition against interest payments appears to have shielded investors from the full force of the fallout. This resilience, along with high demand from Middle Eastern states seeking to park their piles of cash into sharia-compliant investments, has led to a rapid revival in the asset class.
Investor demand estimates vary. Ernst & Young forecasts sukuk demand is expected to triple from the present level to around $US900 billion by 2017. Thomson-Reuters is more conservative but still says demand will almost double from $US240 billion in 2012 to $US421 billion by 2016. Both agree that demand will continue to outstrip supply.
Thomson-Reuters says sukuk issuance, which reached $US121 billion in 2012, will more than double to $US292 billion by 2016.
So it’s a good time to issue. At present, issuance is dominated by sovereign funds and Islamic banks. Despite numerous Western countries amending their regulations in recent years to remove tax barriers to Islamic finance, offers by Western companies have been sporadic and mostly to fund operations in Islamic countries.
German insurer FWU Group raised $US55 million – the largest amount so far by a European company – in its first sukuk in Dubai in December. Several years ago, UK supermarket giant Tesco issued an Islamic bond to fund its Malaysian operations.


Sukuk favours cash flows generated by physical assets and contain various structures designed to provide steady income. These include returns based on a share of profits the asset generates, and often a transfer of ownership to a special purpose vehicle between investors and issuer which then leases the asset to the issuer.
The use of physical assets means it is often viewed as a good fit for infrastructure or property funding, suiting developing countries. The Malaysian government, for instance, has so far raised 1.5 billion ringgit ($458 million) in 2012 and 2013 to fund its biggest construction project, the Sungai Buloh-Kajang mass rapid transit network, with more than 400 million ringgit raised for the first time via a sukuk to retail investors.
Some believe sukuk investors could provide another source of funds for Australia’s high capital intensive industries and fill part of its looming infrastructure funding shortfalls.
National Australia Bank has been preparing to issue sukuk for some time with Malaysian investment bank CIMB for funding diversification purposes. It is understood Australian tax barriers are standing in the way. Non-bank lender FirstMac wants to securitise via sukuk sharia compliant mortgages it has sold in Australia for the past decade.
But where big financial institutions are tentatively exploring its potential, one small Australian company has dived in. In July 2013, a joint venture between Brisbane-based solar producers The Solar Guys and Mitabu Australia plans to raise $100 million in the first Australian dollar-denominated sukuk to build the first of five 50 MW solar power plants in Indonesia. The first one will be based in a “special economic zone” in the province of East Kalimantan on the island of Borneo. SGI-Mitabu plans to raise $500 million in total to finance all of the plants.
Mitabu director Rusdyi Mitabu is leading the financing, but the idea to use a sukuk initially came from the Kuala Lumpur branch of investment bank Kuwait Finance House. AM Bank (IAG’s joint venture partner in AmG Insurance) will lead the second $100 million tranche to build the next 50MW plant in either Bali or West Kalimantan.


SGI-Mitabu is raising the funds via the Malaysian International Business and Finance Centre on the island of Labuan, off the northern coast of Borneo. This was set up to attract capital by minimising Malaysian taxes for offshore issuers raising money for non-Malaysian based ventures. Another attraction of Labuan for Mitabu is the ability to raise the funds in Australian dollars, avoiding swap costs.
While some of the costs of the project will need to be paid in Indonesian rupees and to offshore manufacturers, the strong Australian dollar makes it a good currency to buy assets made overseas, such as solar panels. The panels will be bought from Japanese firm Kyocera.
Sukuk investors are also keen on Aussie dollars. “There is very strong appetite from the market for Australian dollar investments,” Mitabu says. “They would like to diversify away from US dollars.”
Sukuk yields have also recently hit record lows due to investor demand. Mitabu says he is looking to price at an equivalent return to investors of around 8 per cent. That may sound pricey to big companies. But he says on conventional bond markets, given the joint venture’s lack of credit rating, the fact it is relatively unknown and the risk allocated to Indonesia, they were looking at around 12 per cent.
The Solar Guys founder and commercial director, Dane Muldoon, says another reason to finance with the sukuk was good PR given the Indonesian government is keen to promote Islamic finance. He says solar power also suits Islamic investment principles. “Solar power is a good fit [for sukuk] in terms of the environment, in terms of the community,” he says. It is also an infrastructure asset that will have a steady stream of income selling electricity.
“Sukuk investors want to own an income-producing asset that has a consistent income per annum.” Solar power plants also don’t need to be finished before they can start generating an income, so he says benefits should flow to investors within about three months.
SGI-Mitabu is being courted by several other investment banks to do the final three raisings, including Malaysian bank RHB and Goldman Sachs.


As in the traditional bond universe, there are numerous structures. Most now are asset-based, according to the global head of Islamic finance at Allen & Overy, Anzal Mohammed. This means that even though returns from the physical asset are the basis for the sukuk, there is also a guaranteed payment with recourse to the issuer in the event of default, just as in a conventional bond.
Mitabu’s sukuk is of the more traditional asset-backed variety, which means the issuer and the investor, in effect, share a proportion of the profits generated by the asset according to their level of investment. The asset is transferred to a special-purpose vehicle, and the issuer leases it from the SPV, with payments made in the form of rent, thereby avoiding interest.
Because they are like conventional bonds, some asset-based structures defaulted during the GFC due to the debt-like guarantees on returns. In asset-backed structures, investors share more of the risk with the issuer with recourse only allowed to the asset. If it doesn’t earn profits, neither does the investor.
The legal and structuring costs for sukuk are around 20 per cent higher, according to Mohammed. Part of the reason for this is the need to pay an Islamic scholar to rule on whether the sukuk complies with Islamic finance rules. SGI-Mitabu used scholars from the International Research Centre For Islamic Finance at Lorong University in Kuala Lumpur. They have ruled investors cannot trade their certificates until the power plant is constructed as the sukuk will be too much like debt up until that point.
While the pricing SGI-Mitabu could get, and the project being based outside Australia in an Islamic country, meant a sukuk suited its purposes, other Australian companies seeking to tap the sukuk market still face barriers. For larger companies, the pricing differences between sukuk and conventional financing may not be great enough to take a risk in a new market. Then there are the tax barriers.


At present, because sukuk is based on several transfers of assets into and out of an SPV, it falls foul of federal capital gains tax and state stamp duty, as well as income tax laws relating to infrastructure funding. This would generally increase the cost of issuance well above a conventional bond.
Countries such as the UK, Germany, Turkey and Japan have removed similar tax barriers to Islamic finance. Australia’s Board of Taxation recommended amendments to tax laws to remove the double taxation in July 2011, but the federal government has not responded.
Some advisers, however, say potential issuers don’t need to wait for tax reform. Almir Colan, head of the Australian Centre for Islamic Finance, says the tax issues are surmountable now, with separate rulings available from the Tax Office for structures. He also points out Victoria has amended its stamp duty rules to remove barriers to Islamic finance.
Corrs Chambers Westgarth special counsel Rhys Jewell says sukuk has a role to play in financing infrastructure in Australia. But he says sukuk for Australian projects is likely to mainly be a source of diversification and funding competition. “It may be one of the pieces to the puzzle when trying to finance a project especially if there are only a few players that might be able to finance them,” he says. “It may increase the competitive tension between the financiers to help reduce the cost of finance.”
Anzal Mohammad believes Western companies are waiting for a big issuer, a global bank for instance, to test the Islamic market for them.

(Financial Review / 27 March 2013)

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